A great debate is emerging about virtual currencies like Bitcoin and Ethereum - they are either a revolution in foreign exchange or the next Dutch Tulip Bulb bubble. Year-to-date the overall cryptocurrency market has quintupled in value to greater than $100B. The Redwood Investment Team has concluded that while this digital currency market is highly speculative; the more important aspect is the “Blockchain” technology behind cryptocurrencies, which has the potential to be an exciting and investible theme.
Redwood believes “Blockchain” technology could revolutionize the way in which businesses all over the world transact and record keep and our view is corroborated by numerous other leading organizations. The Brookings Institute has suggested that Blockchain is “the Internet before browsers”1 – a foundational technology in its infancy; Klaus Schwab of the World Economic Forum has qualified Blockchain as part of the Fourth Industrial Revolution;2 and JP Morgan has made Blockchain one of its three top priorities for its $9B technology budget in 2016.3
Digital Currency – The Speculative Viewpoint
From an investment perspective, Redwood sees many parallels between the markets for today’s digital currencies and the market for Internet stocks during the early 1990s. Similar to the Technology Bubble, today’s excitement around the myriad of applications for a distributed internet has driven frothy valuations and encouraged a deluge of Initial Coin Offerings (ICO) financing activity. This is evidenced by the digital currency market growing in a twelve-month period at a rate nearly six-times faster than the rate of the dot-com bubble from 1995-2000. 4
While Bitcoin and Ethereum’s Ether have dominated trading volume and conversation, they now comprise less than 65% of aggregate cryptocurrency market capitalization as the aforementioned flood of new issue coins has expanded the market to more than 800 digital currencies. These ICO’s have quickly defined a crowdfunding mechanism that could disrupt traditional venture financing as they do not require standard due diligence examinations and SEC reviews. Pre-product companies like Bancor have successfully raised hundreds of millions of dollars overnight without having to sell any equity. In June 2017 alone, more than $500M was raised from this non-traditional funding channel, up from ~$100M in all of 2016.6
Coincidentally, 400 of these new issue digital coins started trading in the market in the last year as compared to the 406 IPO’s in year 2000.8 Regardless of whether the cryptocurrency valuation bubble is about to burst, Blockchain’s invention may mean the next Google, Facebook or Amazon is in its infancy today, perhaps even funded by an ICO.
Blockchain Technology Explained - How did it come about? And why is it so important?
In the depths of the 2008 recession, a white paper titled Bitcoin: A Peer to Peer Electronic Cash System was published and it outlined a framework for an alternative electronic payment system that relied on cryptographic proof and computational power rather than “trusted third parties” (i.e. financial institutions) to verify and process online transactions.9 The white paper argued that the utility of the internet was diminished by limitations in our banking system – primarily with respect to security, time and cost.10 The proposed solution was an immutable, distributed, public database of timestamped blocks (hence the name) that could maintain a permanent record of every transaction between community participants through a growing chain of complex algorithms and digital signatures.
At present, vast amounts of web data are centralized by trusted third parties on proprietary servers. Collectively, details like search terms, click through rates, transaction history and sensitive financial information paint a comprehensive picture of our digital identities, but are stored in disparate forms and unknown locations – out of our control and vulnerable to attack.
With Blockchain, this data becomes public, yet remains anonymous in a distributed database that is redundant on every participant’s computer. Each input on a ledger is validated by the community before being timestamped, encrypted and locked with a digital signature. The result is a continuously-growing chain of records that is secure from revision. In fact, the process to amend (hack) any single piece of data requires a consensus of network members not only approves the change but also reconciles the algorithmic encryption of every other historical transaction in the chain – a process that is so time consuming and costly it diminishes incentives for bad actors. The result is a peer-to-peer internet community which self-polices automatically and is not beholden to any individual third party. In this way, Blockchain’s construct democratizes information and enhances ownership of digital identities.
In short, the inherent security advantages of Blockchain make the prospect for its near-term adoption high. Overtime, as the technology scales to facilitate higher volume throughput, exciting secondary benefits with respect to transaction time and cost will make Blockchain a threat to incumbent intermediary businesses of all kinds.
Blockchain Technology – Getting Validated & Potential Applications
Seasoned technology venture investors like Reid Hoffman, Andreessen Horowitz, and Kholsa Ventures have all recognized the huge potential for Blockchain and have acquired equity stakes in mature Blockchain projects like 21 Inc, Blockstream and Chain. They recognize the potential in Blockchain’s innovative architecture and believe it could represent the next evolution of the legacy internet protocol system that we all enjoy today12 – primarily with respect to security, but also speed and cost.
The following examples contextualize how a distributed internet can be impactful outside of cryptocurrency trading.
Financial Services. According to a recent IBM survey of 200 global banks, Blockchain technology is being adopted by the financial services industry faster than anticipated. In fact, 15% of banks are expected to use distributed ledger functionality by year-end 2017 and 66% within four years.13 Currently, financial assets are exchanged over antiquated back-office systems, taking days to connect clearing houses and central depositories. Blockchain allows instant verification of a transaction and thus the ability for asset transfers to occur between counterparties without intermediaries – making settlement and reconciliation redundant.14 Given the opportunity, Goldman Sachs Investment Research projects $6B in annual savings alone from implementation in clearing and settlement practices for cash securities, a likely conservative estimate as it excludes application in OTC and derivatives markets.15 Thus, it’s no surprise to see State Street Bank piloting the technology in bond transactions, National Stock Exchange of India exploring its application in “Know Your Customer” functionality, and Nasdaq-Citi introducing a Blockchain-based market for private securities.16
Real Estate. Even more than in financial services, real estate information remains centralized and unreliable. Although entrants like Zillow have democratized market research, innovation has yet to affect the 50-year-old closing process. Buyers and sellers rely on trusted third parties like real estate agents and intermediaries for services like escrow and title verification. These and other related services can cost up to 2% of an property’s value, equating to hundreds of thousands of dollars in commercial deals.17 In a future where Blockchain technology is employed a consensus approval process could replace these intermediaries and significant savings would be achieved. Signs of progress are already being made by public entities in Sweden and Honduras where land registries tracked by Blockchains are reducing fraud and providing millions in tax payer savings.18
Healthcare. On average, Americans visit 18.7 different doctors in their lifetime and while the HITECH Act has encouraged use of electronic health records (EHRs), Premier Healthcare Alliance estimates lack of interoperability of physicians’ local systems costs 150,000 lives and $18.6B per year.19 20 Additionally, digitizing patient medical records has resulted in security concerns as hospitals are falling victim to ransomware attacks with increased frequency. Blockchain technology could address both issues, giving healthcare providers access to longitudinal patient information on a secure, distributed platform. Recently, MIT’s MedRec piloted such a system with Beth Israel Deaconess hospital and the Estonian government experimented on a larger scale securing health records for over one million citizens in response to the 2007 Russian cyberattack.21 22
Voting. From America’s Got Talent to proxy fights, digital and physical voting processes remain opaque as final tallies are made by trusted third parties. The ability to cast votes as anonymized transactions via Blockchain would benefit the democratic process by unlocking the ability for the public to count votes in a transparent record. Given social and economic advantages, Australia’s government-owned postal service recently announced plans to test a digital voting mechanism via Blockchain.23
Public Equity Investment Implications
While the opportunities for Blockchain are powerful and seemingly endless, there is not currently a way to gain direct public market exposure to the technology. However, signs of its influence are emerging within certain sectors and should become more pronounced as Blockchain is more widely adopted.
In Technology, Blockchain’s reliance on distributed processing will require increased computing power and storage, which should drive incremental demand for hardware, semiconductors and public cloud computing. Specifically, incremental demand for graphic processing units (GPUs), memory, servers and storage could result in growth exceeding current projections and provide an upward bias to fab utilization rates, average selling prices (ASPs), ROIC and profitability. Signs of this occurring may be creeping into markets today as some manufacturers are noting accelerating demand from regions where cryptocurrency trading is popular, like China and Russia. While digital currency is the first major Blockchain application, new adaptations should require more computing power and further benefit hardware and semiconductor companies.
Within Financial Services, providers of trusted networks such as credit card companies, transaction processors, money transfer services and custodians are at risk of disintermediation by Blockchain. Using the technology, private company upstart Abra has built a cheaper, faster alternative to the legacy model for servicing $600B of annual global remittance volume.24 Within the complicated world of insurance, startup Dynamis is facilitating peer-to-peer smart contracts using the Ethereum Blockchain, posing a threat to traditional pooled vehicles. However, large incumbents have the opportunity to benefit too. The same insurance giants could use Blockchain to automate underwriting and claims processing, reducing administrative costs and improving customer engagement.25 As discussed, money center and investment banks will likely see efficiency gains as they incorporate Blockchain into ailing FICC and Equity trading businesses.
While Redwood employs a bottom up stock selection investment process, understanding macro implications from major technological transitions is critical to forecasting earnings estimates across industries. Currently, our team is not yet convinced digital currencies will see global adoption and assigns a much higher probability that Blockchain will be a major influence on the economy. We look forward to pinpointing exactly how and hope you will reach out with questions and to share your thoughts.
MIT: Blockchain Overview
Goldman Sachs Thinking Pages: Blockchain Explained
Ted Talk - Don Tapscott: Blockchain's Future
World Economic Forum: Blockchain in Financial Services
Harvard Business Review: Blockchain Beyond Financial Services
Podcast - Tim Ferris: Cryptocurrency Explained